Risk Management Manual of Examination Policies - FDIC

SECURITIES AND DERIVATIVES Section 3.3
INTRODUCTION
Overview
Securities and end-user derivatives (investment) activities
can provide banks with earnings, liquidity, and capital
appreciation. Carefully constructed positions can also
reduce overall bank risk exposures. However, investment
activities can also create considerable risk exposures,
particularly:
• Market risk,
• Credit risk,
• Liquidity risk,
• Operating risk,
• Legal risk,
• Settlement risk, and
• Interconnection risk.
This section provides guidance, policy, and sound practices
regarding:
• Policies, procedures and risk limits,
• Internal controls,
• Unsuitable investment activities,
• Risk Identification, measurement, and reporting,
• Board and senior management oversight,
• Compliance,
• Report of examination treatment, and
• Other guidance (trading, accounting, and information
services).
Use this section to assess how effectively a bank’s board
and management identifies, measures, monitors, and
controls investment activity risks. Incorporate findings
into relevant examination assessments, including sensitivity
to market risk, liquidity, asset quality, and management.
Refer to the Capital Markets Examination Handbook for
reference information on a wide range of activities and
instruments, including fixed income instruments, mutual
funds, derivatives, sensitivity to market risk, portfolio
management, and specialized examination procedures.
That handbook’s information focuses more closely on
specific activities and instruments than this section’s
general guidance.
Policy Statement
The Supervisory Policy Statement on Investment Securities
and End-User Derivatives Activities (Policy Statement)
was adopted by the FDIC, Office of the Comptroller of the
Currency, Board of Governors of the Federal Reserve
System, Office of Thrift Supervision, and National Credit
Union Administration, effective May 26, 1998. The Policy
Statement provides guidance and sound principles to
bankers for managing investment securities and derivatives
risks. It makes clear the importance of board oversight and
management supervision, and focuses on risk management.
The Policy Statement covers all securities used for
investment purposes and all end-user derivative
instruments used for non-trading purposes. It applies to all
federally-insured commercial banks, savings banks, and
savings associations. Notably, the Policy Statement:
• Underscores the importance of board oversight and
management supervision,
• Emphasizes effective risk management,
• Contains no specific constraints on holding “high risk”
mortgage derivative products,
• Eliminates the requirement to obtain the former
regulatory volatility test for mortgage derivative
products, and
• Applies to all permissible investment securities and
end-user derivatives.
The Policy Statement declares that banks should
implement programs to manage the market, credit,
liquidity, legal, operational, and other risks that result from
investment activities. Adequate risk management
programs identify, measure, monitor, and control these
risks.
Failure to understand and adequately manage investment
activity risks is an unsafe and unsound practice.
Risk Management Process Summary
This subsection provides guidance for evaluating a risk
management program’s effectiveness at identifying,
measuring, monitoring, and controlling investment activity
risks. It also includes guidance for assessing those risks
relative to overall risk exposure.
Management should establish a risk management program
that identifies, measures, monitors, and controls investment
activity risks. Its intricacy and detail should be
commensurate with the bank’s size, complexity, and
investment activities. Thus, the program should be tailored
to the bank’s needs and circumstances. Regardless, an
effective risk management program will include the
following processes:
• The board should adopt policies that establish clear
goals and risk limits.
• The board should review and act upon management’s
reports.
DSC Risk Management Manual of Examination Policies 3.3-1 Securities and Derivatives (12-04)
Federal Deposit Insurance Corporation